Foreign Safe Asset Demand and the Dollar Exchange Rate

We develop a theory that links foreign investors' demand for the safety of U.S. Treasury bonds to the value of the dollar in spot markets. An increase in the convenience yield that foreign investors derive from holding U.S. Treasurys induces an immediate appreciation of the US dollar and, going forward, lowers the expected return to a foreign investor from owning Treasury bonds. Under our theory, we show that the foreign convenience yield can be measured by the 'Treasury basis,' defined as the wedge between the yield on foreign government bonds and the currency-hedged yield on U.S. Treasury bonds. We measure the convenience yield using data from a cross-country panel going back to 1988 and the US/UK cross going back to 1970. In both datasets, regression evidence strongly supports the theory. Our results help to resolve the exchange rate disconnect puzzle: the Treasury basis variation accounts for up to 41% of the quarterly variation in the dollar. Our results also provide support for recent theories which ascribe a special role to the U.S. as a provider of world safe assets